The strength of the US dollar played havoc with global capital flows and caught many investors off guard in 2022. As the pace of rate hikes slows in 2023, will the greenback remain in such high demand?
At the BNP Paribas Global Markets Conference APAC, held in Singapore on November 21, speakers outlined the case for continued dollar strength against a volatile global backdrop.
The US dollar soared against other major currencies in 2022 as rising interest rates added to the currency’s safe-haven appeal. At its peak at the end of September, the US dollar index was at its highest level for 20 years.
A retracement in November, on signs that cooling US inflation may allow the Federal Reserve (Fed) to slow the pace of rate hikes, has prompted investors to review their long dollar positions.
However, guest speakers at the conference – including former central bankers and policymakers – cautioned that global monetary conditions were unlikely to turn against the dollar in the near term.
“The US dollar remains a safe haven and a sought-after asset in times of economic uncertainty,” said Sam Lynton-Brown, Global Head of Macro Strategy at BNP Paribas. “We are bearish on the USD in the medium-term, but the USD might prove stronger than expected in the first half of 2023 due to safe-haven demand.”
US policy position
While the US Fed does not explicitly target the exchange rate, a firmer dollar is beneficial from a monetary policy perspective. As well as reducing the competitiveness of US exports, a stronger dollar reduces the cost of imported goods, thus slowing domestic inflation.
While the dollar has come off its highs, it remains in a historically strong position relative to other global currencies. Indeed, the idiosyncrasies of other safe-haven currencies have limited the pace of dollar selling. The Russia-Ukraine conflict has raised the risks for the euro, Japan’s decision to continue yield curve control and the country’s deteriorating trade balance has rendered the yen less attractive, while confidence in sterling took a big hit under the recent short-lived UK government.
Eurozone still risky
The euro gained 5% against the dollar in November on signs that US inflation may be cooling. This rebound has relieved inflationary pressure somewhat as the Eurozone contemplates a tough winter with record-high energy and food prices on the back of reduced supply from Russia.
Speakers at the Global Markets APAC conference concluded that the major driver of this bounceback is dollar selling rather than an improvement in the Eurozone’s fundamentals. Investors are likely to need further signals to justify continued euro buying.
Japan’s alternative path
The Japanese yen has been hit particularly hard, plunging to a 32-year low against the dollar in October.
Adjusted for inflation, Japan’s current real effective exchange rate is almost the same as it was in 1971, indicating that the yen’s value has decreased substantially.
Yet the Bank of Japan is ignoring calls to tighten policy to combat rising inflation, and speakers at the Global Markets conference did not expect a change to the Bank of Japan’s stance any time soon.
“Some observers believe there is a danger of central banks focusing too narrowly on inflation targeting and are calling for revisions to the monetary policy framework,” said Hiroshi Shiraishi, Senior Japan Economist at BNP Paribas.
Asia’s emerging markets have been particularly vulnerable to volatile exchange rates in the past. As their currencies depreciate against the dollar, central banks are often forced to tighten monetary policy to limit outflows, sacrificing growth in the process.
That said, lessons have been learned and the region has managed recent economic challenges well, according to the World Bank.
For example, the Indonesian rupiah has remained relatively strong thanks to fundamental resilience measures, such as a more diverse economy, well-managed government and banking-sector balance sheets, and the abandonment of rigid exchange-rate pegs.
BNP Paribas’ Markets 360 team notes that the battle against inflation is far from over.
“Despite a likely steep fall in inflation next year, underlying price pressures will persist, preventing the Fed and the ECB from cutting rates,” said Luigi Speranza, Head of Markets 360 and Chief Economist at BNP Paribas, speaking at the Global Markets APAC event.
For investors, this implies weak economic growth and continued uncertainty in 2023 – both conditions where the world’s reserve currency can be expected to demonstrate its safe-haven appeal.